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They say that the best investing is dispassionate. Fundamentals improving? Buy. Fundamentals deteriorating? Sell. No celebrations or funerals, just cold hard facts. I have to recognize though a sense of relief that Gramercy (GKK) reached a positive settlement for Realty and will soon file its financial statements.

You might wonder why I am feeling relief and not joy - was not the settlement a positive outcome?

It was. The thesis supposed a complete loss of Gramercy Realty and hinted the possibility of a legal struggle that could have taken months. Instead, the uncertainty has been completely removed with Gramercy receiving $10 million in management fees and at least $3.5 million in incentive fees for administering Realty. We do not know all the details but this is much better than getting nothing.

Even more, if you are following closely the situation you might have heard that CDO 2005 excess interest income is flowing to corporate. In case you miss that important point, let me repeat it. CDO 2005 is alive and its cash flow faucet is open. Fitch broke the news a month ago.

Since last review, the CDO exited its reinvestment period. Six assets are no longer in the pool, including four CRE CDO securities sold at a loss; one mezzanine loan paid in full; and one real estate owned (REO) office property, which was exchanged for a performing office loan, as allowed under the transaction documents. While all overcollateralization tests are now passing, as of the June 2011 trustee report, the CDO was previously failing at least one test since March 2010 leading to the diversion of interest payments due on the junior classes to pay down class A-1.

But the the investing emphasis in downside protection takes its toll. It’s a life of more question than exclamation marks and feeling when proven right is not the joy of a Young Frankenstein surprised by his creation.

Months of checking and double checking the thesis while being patient creates anticipation with no uncertainty. Actually, the goal in investing is to avoid surprises. Good downside protection analysis should provide as much certainty as possible. And with it, it should bring the death of joy.

What do we get in return? A smirk in the face, a little gloat and relief. Being human, I suppose that’s the consequence of enjoying more the process than the outcome.

Earnings Power

I have been receiving lots of questions about the consequence of the Gramercy Realty deed-in-lieu of foreclosure agreement. The following is my best guess of Gramercy’s current earnings power. Please corroborate the numbers as soon as we get the financial statements. There may have been some big changes over the last year … it has been a long time.

NII net of preferred dividends 53M – 63M
CDOs Excess Cash Flow 60M – 70M
Preferred Dividends (7M)
Fees 17M – 20M
CDOs Senior Collateral Management Fees 3.5M
Gramercy Realty Management Fees 10M
Gramercy Realty Incentive Fees 3.5M – 6.5M
SG&A (28M)
FCF pretax 42M – 55M
FCF pretax per share $0.8 – $1.1
Unrestricted Cash 150M

Using the current market multiple for Newcastle Investments (NYSE:NCT), that is a very similar company to Gramercy, we arrive to a target valuation between $6.6 and $7.7 per share. And I consider NCT very cheap indeed.

NCT GKK
Market Cap 392M 160M
Unrestricted Cash 34M 150M
FCF pretax 84M 42M – 55M
FCF multiple 4.3x 4.3x
Price Target $4.9 $6.6 – $7.7

Granted, Newcastle is already paying a dividend of $0.4 per share and we are still waiting to know what Gramercy decides on this issue. At the same time, Gramercy has a better risk profile with a large percentage of its value consisting of cold hard cash and fees.

So the answer to your question readers is yes. Gramercy Capital is cheap and safe.

What’s Next?

The answer is simple: Here come the catalysts. And it should be an avalanche over the next few months.

  1. Financial Statements: The company already announced that we will have a 10K before the end of September. It will take some time to know what has been going on over the last year and to finally see the large unrestricted cash consequence of selling the corporate New York leaseholds … if there are no other large material transactions besides the preferred buybacks and the healing of CDO 2005.
  2. Preferred Share Dividend: Including the payment of 12 quarters of arrears. As you can imagine, that by itself makes the preferred shares trading at par a very nice opportunity. I hope that after all the Gramercy write-ups you understand why I am looking for more by buying the common.
  3. Common Equity Dividend: Gramercy is in no hurry to reestablish the dividend considering the recent very large accumulated losses and the large pipeline of opportunities in the CRE space. However, considering the experience of similar companies like RAIT Financial (NYSE:RAS) and Newcastle Investments, I would not be surprised to see a small dividend of around $0.3 per year (30% of FCF) that would permit Gramercy to tap the capital markets in the future for the plenty of available accretive opportunities. Hey, I would not mind that FCF reinvested at 20% ROIs.
  4. Foreclosing Good Collateral: With lots of cash, two CDOs cash flowing and management fees, there should be no worries about the future and Gramercy can be more aggressive. One way is taking control of cash flowing collateral by using the replacement strategy. Instead of continuing to extend these CDO loans, why not take control of the property at great prices? Compared to banks, we don’t have regulator pressure to sell them and can receive rent income instead (ie: RAIT Financial). Yes, we can benefit from deed-in-lieu of foreclosures - we are not just on the receiving end.

With Gramercy Realty’s uncertainty resolved and CDO 2005 cash flowing ahead of schedule, two big mysteries were solved. But I start to wonder about the dog that has not barked … what will Gramercy do with all that unrestricted cash?

Gramercy Corporate has not been in the news in any big transaction, except for the curing of CDO 2005, and has not filed an 8K detailing one either. Without financial statements I am in the dark (as with everyone else), but it seems Gramercy has not done much with that cash.

Why?

It is not for lack of opportunities or not enough time to close them. For example, competitors have been active over the last year. My impression is that Gramercy is preparing something big but needed to resolve Realty first before committing.

What could that be? I wish I knew but let me throw one possible scenario just for the sake of showing the range of possibilities that open up after the Realty settlement: What if Gramercy is planning something massive, like buying a large part of the dead parrot CDO 2007 bonds?

Let me repeat, this is pure speculation. But I have seen other non agency mREITs buying tranches of their non cash flowing CDOs, not because they want to cure them, but just because it is good allocation. When an mREIT has other sources of income, like fees and other flowing CDOs, it can take advantage of the acceleration of principal payments for the CDO senior notes.

Gramercy is both a lender and an operator of real estate, and is able to buy its debt at a discount, so nothing stops it. And competitors NorthStar Financial (NYSE:NRF) and Newcastle Investments have done it too.

It might also explain why the Realty negotiations reached port so soon after a change of Roger Cozzi’s and Tim O’Connor’s incentive package, which nstead seemed to tip that Gramercy was preparing for a long protracted negotiation. The widening spreads of the last weeks may have provided a large buying opportunity that might have convinced Gramercy to soften a tough negotiation stand. Add that the difficult economic conditions might make difficult a turnaround of Realty .. and voila?

After seeing recently buybacks of flowing CDO bonds in the 50% of par, it would not be a shock to see the senior CDO 2007 bonds below 40%, and that might be great. But I do not know for sure.

What Can Go Wrong?

Gramercy has been in the news lately with the fight over two distressed loans: Jameson Inns and Hilton Las Vegas. And more will probably come. However the situation is much different from 2008-2009 when delinquent loans could have compromised the viability of Gramercy. Now Gramercy can negotiate from a position of strength when the worst that can happen with a defaulting loan is a quarter or two of CDOs not cash flowing, but in return it can take control of good properties at bottom prices.

In terms of the macro situation, a Japan type of scenario with interest rates at zero as far as the eyes can see could be positive. Banks with large concentration of CRE loans have been restricted by tough regulators of lending more to the sector, so the conditions have been fantastic for the remaining lenders with CRE loan yields of 5% plus.

The only bad scenarios that I can foresee at the moment is a 1930s-style depression or a large capital misallocation. And there is no evidence that we are facing either of those.

Disclosure: Author is long GKK

Source: Gramercy Capital: It's Alive?